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High beta US smaller caps boost

Merrill Lynch and Gartmore funds outperform over three years in sector where high returns are not tied to volatility

High beta American smaller companies funds have outperformed over the three years to April but strong returns have not been restricted to the more volatile funds.

Merrill Lynch's American Opportunities fund and its institutional clone, American Smaller Companies, achieved the highest returns over the three years to April 2001, returning 75.33% and 81.05% respectively.

While the funds were able to strongly outperform in a bull market, they proved closely correlated to the market during the downturn last year.

Over one year to the start of April 2001, American Opportunities returned -11.09%, compared to an average return in the sector of -9.59% over the same period.

Chip Skinner manages Merrill Lynch American Opportunities along with Ron Zibelli. He said the underperformance over the past year is attributable to negative market conditions and the close correlation of small-cap growth to the Nasdaq in late 2000 to early 2001.

The fund has an annualised alpha of 13.03%, which Skinner attributes purely to stock selection. It also features a high beta of 1.38%, compared to the sector mean of 1%. Skinner said the high beta is due to the fund's strict adherence to a growth style.

'The high beta goes back to the fact that we tend to invest in the fastest growing companies, which have higher valuations compared to the broader market,' he said.

Skinner is unperturbed by the short-term performance volatility his style invites, believing that growth investment will deliver over the long term.

'We believe in investing in companies that can grow earnings or cashflow at a 20% plus rate, under the premise that, over time, share prices tend to track earnings growth. This is a good strategy to achieve outperformance,' he added.

In recent weeks, Skinner has positioned the fund into more defensive growth areas, moving overweight in financials and business services. He has also reduced his technology holdings from a 45% high during the tech boom in 1999 to a marginally underweight position of 18% but has just begun adding to his biotech positions, believing the sector has now reached its bottom.

Skinner said he believes performance will pick up within 12 months, once the market feels confident the current economic slowdown is near an end, allowing growth to come back.

One fund manager who has proved able to outperform whatever the market conditions is Ira Unschuld, manager of Schroders' US Smaller Companies fund. The fund has outperformed the market over three years and is one of the best performing unit trusts across all sectors over 10 years to May 2001.

Managed by Unschuld since 1992, the fund has returned 843.4% after initial charges over 10 years, and over the three years to the end of May 2001, returned 50.75%, compared with a sector average of 26.83% for the same period.

This performance has added to the fund's high alpha of 9.93%, compared to the average 1.45%, however, has not come at the expense of higher volatility, posting a well below average beta of just 0.55%.

Unschuld said the high alpha can be accounted for by his disciplined approach to stock picking and profit taking. Unschuld said a brutal sell discipline is needed to prevent the compounding of any losses and he operates a high portfolio turnover, which he says was 175% of the fund last year.

'What I focus on is investing in companies with real earnings and I am very disciplined in terms of taking profits. I have about 100 holdings and the top 10 will be less than 20% of the fund,' he said.

Unschuld's diversified portfolio construction is based on identifying emerging trends in the market through meeting between 300-500 companies per year and using the wealth of experience he has gathered.

The fund achieved an annualised return over one year to the end of May of 22.57%, compared to a sector average of -9.59%, well outperforming its peers in a bear market.

He said: 'My style does very well when the market is fundamentally driven. When the market is very speculative, as it was in 1999, I won't make as much money.'

Unschuld avoids biotech companies, believing it is too high a gamble due to his lack of specialist knowledge on their products. He is currently underweight technology, with a 16% weighting in the sector, compared with a high of 30% last year.

Unschuld's largest sector position is currently in healthcare, where his holdings include Invacare, a pharmaceutical distribution company, and outpatient care contractors, Rehabcare Group.

Nick Ford, manager of Gartmore's American Smaller Companies fund, is also bullish about the healthcare sector, believing that along with education services and energy-related stocks, it provides the best growth potential over the coming months.

In healthcare, he likes Quintiles and Pharmaceutical Product Development, companies which provide testing services for the pharmaceutical and biotech industries. These companies tend to be less volatile, with visible earnings, and lack the reliance on a handful of customers or products that marks biotech small caps, he said.

Ford monitors risk in his fund by stringently calculating the return per unit of risk and prefers to run a relatively concentrated portfolio, typically between 50-80 stocks. He currently has 72 holdings in the portfolio. He also operates a strict sell discipline, with an average annual portfolio turnover of 200%.

Ford's fund has an annualised alpha of 5.98%, compared to a sector average of 1.45%, and an above average beta of 1.23%. The fund outperformed over the three years to April 2001, returning 45.12%.

In the year to April, since Ford took over management of the fund, it fell by 8.06%, beating the sector average by 1.53%.

He said these are currently being positioned towards a stronger growth bias. Weightings in technology and biotech were upped in April and May, catching the market bounce.

Price said the funds are broadly diversified across all the market sectors, with the risk profile being more stock specific.

He feels the lack of market leaders and companies with a strong competitive advantage among technology companies in the US small cap arena has hampered investment performance, leading him to opt for exposure to biotech instead.

'We could not find much that matched our market cap criteria in technology but we could find it in life sciences, so the growth part of our portfolio was built up in that industry,' he explained.

Price highlights drug and predictive medicine developers, Millennium Pharmaceuticals, as one major biotechnology holding he believes currently represents good value.

The company was trading at $42.69 as of 6 June 2001, off a 52 week high of $89.82, offering scope for growth at value, he said.